Differences in economic developments in euro area countries are making area-wide statistics difficult to interpret. In recent months, attention has focused on the divergence of business cycles between the euro core and periphery, and now even within the core. The implications of these developments are still unclear. With rapid and wide-ranging structural changes taking place, even country-specific statistics have become misleading. At the same time, there is an alarming knowledge gap regarding developments at disaggregated levels, given the difficult and ongoing process of harmonisation of statistics in Europe. Individual governments should be concerned, as the automatic adjustment mechanisms of labour and product markets are clearly being tested earlier and more severely than had initially been anticipated.

Should the European Central Bank (ECB) also be concerned? Monetary policy can no longer address imbalances that emerge within the euro area. Why, then, is it important for monetary authorities to monitor internal divergences? There are two important reasons. First, the presence of diverging internal trends can complicate decision-making. In order to prescribe an appropriate mix of policy measures, such weighted averages which underlie policy decisions could usefully be supplemented with more disaggregated statistics. Second, as several observers have pointed out, the Economic and Monetary Union (EMU) can be brought into crisis if one individual member state starts a serious internal political debate about leaving1. This would represent a worst-case scenario, in which a country retrospectively considers the lack of a national monetary instrument prohibitively costly and the current arrangements politically unsustainable.

Euro-area member countries agreed to the structures of a common currency in part for economic reasons; these arrangements are expected to place member countries on superior growth and development paths as compared with alternative structures. In the event that this hope is not satisfactorily realised, there may be a debate about disengaging. While we do not expect this to take place, we do believe that EMU stands to perform better long term if the ECB and political authorities put careful thought into some of the ways in which it might possibly encounter crises.

Monetary thermometer

One way to answer these questions is to look at a benchmark for monetary policy, which makes possible comparisons between “ideal” policy stances for the euro area average versus individual member countries. Below, we have incorporated one such benchmark into an indicator which we call the “monetary thermometer”, because it tries to determine whether the economy is too “hot” or too “cold” for the current euroarea monetary policy stance. An economy that is too hot risks overheating because monetary policy is too loose for local conditions, while the reverse is true for an economy that is too cold.

The particular benchmark that we use is based on the work of John B. Taylor, who has proposed a simple monetary rule that has received a great deal of attention13. While it is widely acknowledged that neither the European Central Bank nor the United States Federal Reserve could consider giving up discretionary authority over monetary policy given the ongoing turbulence and uncertainty of global macroeconomic developments14, the so-called Taylor rule constitutes a widely accepted benchmark for monetary policy. As such, it has value as one of several tools for analysis. A Taylor rule is a very simple formulation by which monetary authorities adjust the short term interest rate in response to two factors only: inflation deviations from a target level, and the size of the output gap. A constant term indicates what level of the short-term interest rate is consistent with full employment.

Taylor’s original formulation was r = p + 0.5y + 0.5(p-2) + 2

where r is the short interest rate controlled by monetary authorities, p is the rate of inflation over the previous four quarters,y is the per cent deviation of real GDP from a target.

From the formulation above, it can be seen that Taylor assumed the target level of inflation to be 2 per cent, and the economy’s equilibrium long run real rate of interest to also be 2 per cent. Thus, when inflation is stable at 2 per cent and the economy is operating at its potential, nominal interest rates should be 4 per cent. In empirical tests, the Taylor rule has been found to track actual monetary policy surprisingly well from the late 1980s until the present, both in the United States and in several large European countries.